Liquidity Provision

A liquid product has a tradable market with tight bid and ask prices and sufficient size, in which there are opportunities to buy and sell derivative warrants. The provision of liquidity is an important feature of derivative warrants because it allows investors to buy and sell derivative warrants that may otherwise be illiquid (that is, have insufficient supply or demand). Issuers may provide liquidity in respect of their products through a designated liquidity agent (called a “liquidity provider”). In Hong Kong, liquidity providers are commonly known as “market makers”.

Each issuer must appoint one liquidity provider, who must be an Exchange participant, for each of its products.

Most derivative warrants do not have public holdings on their first listing dates. A liquidity provider provides quotations for a particular derivative warrant to support a tradable environment for that product. Such quotations take into account the prevailing market conditions affecting the underlying asset, such as hedging costs and liquidity, spread and volatility of the underlying. Liquidity providers provide liquidity by inputting orders into the trading system of the Exchange when they receive “quote requests”. They do so according to the committed service level set out in the relevant listing document. These standards typically include:

(a)  the maximum response time – i.e. the maximum time it will take to submit a pair of quotes after a request is received;

(b)  the maximum spread between the bid and ask price;

(c)  the minimum quote size; and

(d)  situations in which a quote will not be provided.

Under certain circumstances, liquidity providers are required to provide “active quotes” (that is, even where no request has been submitted by investors) by actively inputting orders into the Exchange’s trading system.

Each liquidity provider is currently identified by a 4-digit broker ID code of 95XX, 96XX or 97XX. The relevant listing documents of an issuer set out the exact obligations of its liquidity provider.

In circumstances where the outstanding quantity of a derivative warrant in the market increases, the liquidity provider may be less active in providing quotes for such derivative warrant. This is because the key role of a liquidity provider is to facilitate liquidity when there is limited or no market liquidity on the derivative warrant (such as when the products are newly listed on the Exchange with limited or no trading by market participants or investors) and to support a tradable environment for the  derivative warrant. If a derivative warrant is not eligible for active quotes due to the fact that there is more than 50% of its aggregate number outstanding in the market, then there may not be any active quote from the liquidity provider. You can find out the outstanding quantity of derivative warrant as of the previous trading day on the HKEX’s website.

Where the number of market participants for a particular product grows, the “market force” increases, and the product becomes less dependent on the liquidity provider as the sole source of liquidity. By implication, the role of the liquidity provider becomes less important when there is a higher number of particular derivative warrant outstanding because this means there are more investors trading in the product, leading to a natural market.

No. Liquidity providers are not required to support prices of derivative warrants. In practice, like other market participants, a liquidity provider is free to buy and sell at any price.

Each series of derivative warrant will have only one liquidity provider appointed for such series.

You can obtain the liquidity provider’s name and contact details in two ways:

(a)  Visit the HKEX’s website: The designated HKEX’s website lists all the liquidity providers for all derivative warrants listed on the Exchange.

(b)  Check the relevant listing documents of the derivative warrant.

Simply contact the liquidity provider directly during trading hours on a trading day at its designated phone number. 

Through the liquidity provider, the issuer takes into account the prevailing market conditions affecting the underlying asset (e.g. hedging costs and liquidity, spread and volatility of the underlying) in the quotations provided to the market.

Not necessarily. Trading derivative warrants is similar to trading stocks listed on the Exchange. Any investor’s bid or ask price may be accepted and traded upon by other investors. You may also place orders just like trading in listed stocks. However, there may not be sufficient interest in trading such derivative warrants.

If the appointed liquidity provider is no longer an Exchange participant, it cannot continue to provide liquidity. The issuer must appoint another liquidity provider in its place.

The Industry Principles set out the best practices on liquidity provision standards for listed derivative warrants, which issuers are required to follow and cannot opt out.

The Industry Principles are general guidance for issuers and are not binding commitments nor do they give rise to enforceable obligations. For example, they do not give investors any specific rights against any issuer.

Occasional failure to comply with the Industry Principles will not in itself render an issuer or its liquidity provider liable to any sanction or enforcement action. That said, compliance with the Industry Principles is relevant to the Exchange’s assessment of an issuer’s suitability to list derivative warrants. The Exchange will actively monitor issuers’ performance and request for explanations why an issuer has not complied with certain Industry Principles.

Quote request is one of the methods in which liquidity is provided. It refers to the provision of liquidity by entering orders into the Exchange’s trading system in response to an investor’s request.

The Industry Principles set out the tightened liquidity standards to be adopted by each issuer in its listing documents. Quote request standards are the minimum service level for all derivative warrants applicable to all possible market conditions (regardless of the underlying assets), subject to certain exemptions set out in the listing documents.

The following table summarises the current service levels.

When a liquidity provider responds to your quote request, it must continue to hold a quotation (which effectively means it must continue to make available an offer to trade for investors) for at least 5 minutes after it is posted on the Exchange’s trading system upon your request. This means that you can accept the quote (that is, agree to trade on that basis) within such 5 minutes, if it has not lapsed (see below).

However, it is important to be aware that even within those 5 minutes, the liquidity provider may need to adjust the bid and ask prices to take into account prevailing market conditions and changes in the price of the underlying asset. If that occurs, the liquidity provider will “refresh its quote” – that is, an adjusted quote will be posted on the Exchange’s trading system.

More importantly, if a liquidity provider’s quote is being traded by another investor within the 5 minute holding time and the quotation lapses, you need to submit another quote request if you wish to trade.

The liquidity provider is not obliged to provide quote upon request in the following key situations:

(a)  during a pre-opening session or a closing auction session (if applicable);

(b)  during the first 5 minutes of each morning session or the first 5 minutes after trading commences for the first time on a trading day;

(c)  when the derivative warrant or any underlying asset is suspended from trading for any reason;

(d)  when there is no derivative warrant available for market making activities;

(e)  if the theoretical value of the derivative warrant is less than HK$0.01;

(f)  where the underlying asset is an index, if there occurs or exists any suspension of, or limitation imposed on, trading of options or futures contracts relating to the index or if the index level is not calculated or published as scheduled for any reason;

(g)  when there are operational and technical problems beyond the control of the liquidity provider that hinder the liquidity provider’s ability to provide liquidity; or

(h)  if there is a “fast market” which materially affects the issuer’s hedging ability.

These circumstances are stated in the relevant listing documents. 

If trading in the underlying asset of a derivative warrant is suspended, trading in such  derivative warrant will also be suspended until trading in the underlying asset resumes. Investors must understand and take into account the risks arising from a loss of time value during a suspension period.

“Fast market” refers to situations where the financial markets experience exceptional price movements and high volatility over relatively short periods of time, which can result in a sudden increase in risk and uncertainty, possibly affecting issuers’ hedging abilities.

For example, these situations may include:

(a)  financial uncertainty - exceptionally volatile market conditions linked to financial uncertainty, for example, the period following Lehman Brothers’ bankruptcy in September 2008 and the “flash crash” of 6 May 2010, when the Dow Jones Industrial Average suffered its worst intra-day point loss; and

(b)  underlying uncertainty - the occurrence of events causing the intraday market price of the underlying stock or index to experience significant fluctuations and/or a material reduction in liquidity of the underlying, for example, Japan’s earthquake on 11 March 2011 which resulted in a drastic fall in Nikkei index in the immediately following period and fluctuation in prices of the related derivative warrants.

These are just possible examples of fast market events. Depending on circumstances, some market events may trigger a VCM which may possibly result in a fast market.

It is generally more difficult to provide quotes momentarily when the price of the underlying asset is changing rapidly within a short period of time.

System difficulties and failures can affect the ability of a liquidity provider to provide quotes within the service level set out in relevant listing documents or provide any quote at all.

A system failure will be notified to the market as soon as practicable and shall be fixed within the shortest possible time.

The issuer will commit to Quote Request obligations during the day, including during the cooling off period, unless an exemption is obtained for Quote Request if there is a “fast market” which materially affects the issuer’s hedging ability.

Active quotes refer to the provision of liquidity where a liquidity provider actively inputs orders into the Exchange’s trading system.

The Industry Principles describe an active quote standard for listed derivative warrants with an active underlying asset, provided certain active quote criteria are met.

For further information, please refer to section 4 of the Industry Principles.

Generally speaking, yes. However, active quotes may not strictly be “continuous” because liquidity providers may need to pause the provision of active quotes for a reasonably short period of time to adjust quote parameters in response to market conditions or operational needs.

Roughly speaking, active quotes should be provided for at least 90% of the time of a trading day for derivative warrants that meet the criteria for active quotes and each pause should not exceed 10 minutes.

No. Unlike quote request, there is no minimum holding time for active quotes.

Issuers are only required to provide active quotes during the “Qualified Period”. This means the period when:

(a)  the active quote criteria set out in paragraph 4.2 of the Industry Principles are met; and

(b)  none of the exemptions set out in paragraph 3.3 of the Industry Principles applies.

Issuers are only committed to providing active quotes for derivative warrants that satisfy the following criteria (as measured on a real time basis):

(a)  an active underlying;

(b)  50% or less of their aggregate number outstanding in the market;

(c)  remaining time to expiry of at least 30 calendar days (for instance, if the expiry date of the warrant is 2 January 2013, active quote should be provided by the liquidity provider up to and inclusive of 3 December 2012) ;

(d)  moneyness between 20% in-the-money and 20% out-of-the money. “Moneyness” is derived by comparing the spot price or level of the underlying and the exercise price or strike level.

For further information, please refer to paragraph 4.2 of the Industry Principles.

A liquidity provider’s quotation for derivative warrants must be based on the actual market conditions. There are three key considerations for an issuer when deciding if active quotes can be provided:

(a)  if the derivative warrant is suitable in terms of demand and risk management;

(b)  if the market conditions affecting the underlying asset, such as its liquidity and the availability of hedging, permit active quotations; and

(c)  the prevailing market conditions affecting the derivative warrant itself, such as supply and demand patterns.

An “active underlying” means local indices (such as the Hang Seng Index and Hang Seng China Enterprises Index) and stocks listed on the Exchange which are eligible for CBBC issuance. These represent stocks with the highest turnover in the market.

CBBC eligible list is generally updated on a quarterly basis and posted on HKEX’s website.

Investors should pay attention to the change in the eligible underlying and the effective date of the eligible list. An underlying previously eligible for CBBC issuance and is removed from the current eligible list will no longer be an “active underlying”. As a result, derivative warrants with that particular underlying will cease to be subject to active quotes commencing on the effective date of the eligible list.

On the other hand, a newly added eligible underlying will become an “active underlying” and will be subject to active quotes commencing on the effective date of the eligible list (assuming the criteria for active quotes set out in paragraph 4.2 of the Industry Principles are all met).

If you want to know whether a particular derivative warrant is eligible for active quotes at any particular time on a trading day, you may contact the issuer to ask if such derivative warrant meets the active quote criteria.

The list of derivative warrants which were eligible for active quotes based on market data as of close of trading on a trading day will be included in each issuer’s daily trading summary published on the next trading day. If you wish to use such market data as a general reference point, please note that such data of derivative warrants is historical.

Such information included in an issuer’s daily trading summary will only show historic data as of the close of trading on the previous trading day for general guidance only. You must not assume that such information is accurate, complete or up-to-date. You should not rely on such historic list as an indication that a derivative warrant listed in such daily trading summary actually meets the active quote criteria at any other time.

The time value of a derivative warrant erodes rapidly towards expiry, making it more difficult to provide active quotes. Active quotes are therefore only able to be provided for a derivative warrant the value of which is not materially affected by the erosion of its time value.

“Moneyness” describes where the derivative warrant’s exercise price or strike level is in relation to the price or level of the underlying asset.

In the case of a call warrant, if the exercise price or strike level is:

(a)  above the price or level of the underlying asset, the warrant is said to be “out-of the-money”; or

(b)  below the price or level of the underlying asset, the warrant is said to be “in-the money”.

Numerically, moneyness of a call warrant is calculated by reference to the difference between the underlying asset’s price or level and the exercise price or strike level, divided by the underlying asset’s price or level, as illustrated in the table below.

In the case of a put warrant, if the exercise price or strike level is:

(a)  below the price or level of the underlying asset, the warrant is said to be “out-of- the-money”; or

(b)  above the price or level of the underlying asset, the warrant is said to be “in-the money”.

Similar to a call warrant, the moneyness of a put warrant is calculated by reference to the difference between the exercise price or strike level and the underlying asset’s price or level, divided by the underlying asset’s price or level, as illustrated in the table below.

Active quotes may not be continuous because liquidity providers may need time to pause the provision of active quotes for a reasonably short period of time to adjust quote parameters in response to market conditions or operational needs.

Common causes of these short interruptions include the following:

(a)  a sudden or material change in the trading pattern of the derivative warrant, such as where a relatively inactive derivative warrant suddenly becomes active;

(b)  news is published that might have an impact on the market price of the underlying. For example, a change in forecast earnings or proposed dividends;

(c)  the underlying or the stock market experiences exceptional price movement or high volatility over a short period of time which materially affects the liquidity provider’s ability to source a hedge or unwind an existing hedge;

(d)  the underlying stock trades at a wider bid-ask spread than normal which causes the spread in the derivative warrant to exceed the maximum level specified in paragraph 4.9 of the Industry Principles;

(e)  the liquidity provider reasonably suspects any potential mispricing, system issue or error;

(f)  the liquidity provider reasonably suspects abnormal trading in respect of the underlying;

(g)  operational and technical problems such as computer network disconnection, loss of data feed, loss of connectivity with the Exchange or technical issues which arise in the issuer’s computer system; or

(h)  the liquidity provider will suffer, or expects to suffer, a financial risk due to frequency of trades and quantity of trades in relation to its derivative warrant.

An issuer may stop providing active quotes for a derivative warrant on a trading day if that derivative warrant no longer meets the active quote criteria stated in paragraph 4.2 of the Industry Principles. Individual issuers may voluntarily decide to keep providing active quotes, or may switch to providing liquidity on a quote request basis in accordance with the minimum liquidity service levels.

The bid and ask spreads for active quote are tighter than the maximum spreads prescribed for quote request. These tightened spreads are as follows:

Spreads for CBBCs are wider than those for derivative warrants because the price of CBBCs is generally more sensitive to movements in the value of the underlying asset, meaning that it is more costly for the issuer to hedge that underlying asset.

Investors should be aware that standards for active quotes described in the Industry Principles are intended to apply to normal market conditions. Provision of active quotes may be affected where there are abnormal or exceptional market conditions.

Quotes provided by liquidity providers necessarily reflect the liquidity of the underlying securities or indices at any given time. If the liquidity of the underlying is impaired by conditions surrounding a VCM event, or by the VCM itself, the liquidity of the  derivative warrant may be adversely affected in terms of quote size and spread relative to more normal market conditions.

During the 5-minute cooling off period after triggering of the VCM, where issuers’ hedging ability is materially affected due to the uncertainty in the underlying securities or index, it is possible that the minimum service level for active quotes will not be fulfilled, such as no bid-ask quotations, widening of bid-ask spread and reduction in quote size.

Similarly, after the 5-minute cooling off period, liquidity provision may still be affected if issuers continue to experience hedging difficulties. Under such circumstances, Liquidity Providers may not fulfil the minimum service level for active quotes as described in the Industry Principles.

However, issuers will use best efforts to meet quote request requirements.

Yes, unless the situation falls within any of the circumstances described in paragraph 3.3 of the Industry Principles.

The quote size offered by the liquidity provider is limited by the actual liquidity of the relevant hedging vehicle (e.g. the underlying asset or the listed or OTC options linked to the underlying asset).  In this case, the liquidity provider may not be able to buy all 1,000 board lots of your call warrants if the liquidity provider cannot unwind such hedging vehicle for all of the 1,000 board lots of your call warrants (for example, because the relevant hedging vehicle is illiquid).  The minimum quote size that a liquidity provider is committed to quote is 20 board lots. 

The last reported price (or the nominal price) is not necessarily the same as the warrant’s actual theoretical value. In this case, the most likely reason is that the actual theoretical value of the call warrant is less than HK$0.01.  This is one of the circumstances in which a liquidity provider is not required to respond to any quote request.

No.  If an existing quote that complies with the minimum service levels is available, the liquidity provider will be deemed to have complied with its liquidity obligations.

The liquidity provider is only required to commit to the minimum service level. If your request for a bid-ask spread reduction is a tighter standard than the minimum service level, the liquidity provider is not obliged, and may not be able, to provide a tighter spread. It is because the bid-ask spread may change from time to time or even widen according to the prevailing market conditions affecting the underlying asset (such as hedging costs and liquidity, spread and volatility of the underlying).

If the liquidity provider has provided active quotes that comply with the spread requirement for active quotes as prescribed in the Industry Principles, it should not be necessary to make a separate quote request for such products as the bid and ask spreads for active quotes are tighter than the maximum spreads prescribed for quote request.

The liquidity provider is exempted from providing liquidity when there is a “fast market” which materially affects the issuer’s hedging ability. “Fast market” refers to situations where the financial markets experience exceptional price movements and high volatility over relatively short periods of time, which can result in a sudden increase in risk and uncertainty, possibly affecting issuers’ hedging abilities.

A significant move in the Hang Seng Index or the overall market may or may not result in exceptional price movement and high volatility of the underlying stock.  In this case, the liquidity provider may need to demonstrate to the Exchange that its hedging ability has been materially affected by exceptional price movement during a short period of time. 

Time to maturity is one of the criteria for active quotes.  As your call warrant has a maturity of less than 30 calendar days, it does not meet the active quote criteria set out in the Industry Principles.  In this case, you could contact the issuer to make a quote request. 

Issuers provide active quotes for call warrants with moneyness between 20% in-the-money and 20% out-of-the-money.  Where the spot price of the underlying stock is HK$50, an exercise price of the call warrant between HK$40 (+20%) and HK$60 (-20%) meets the ±20% moneyness criteria.  In this case, your call warrant should be eligible for active quotes (subject to it meeting the other criteria), as the exercise price of HK$45 falls within the ±20% moneyness range.

Issuers provide active quotes for derivative warrants with moneyness between 20% in-the-money and 20% out-of-the-money.

Where the level of the HSI is 18300, call warrants with strike level between 14640 (+20%) and 21960 (-20%) meets the ±20% moneyness criteria.   In this case, your call warrant does not fulfil the active quote criteria because the strike level of 22900 falls outside the ±20% moneyness range.

As a result, you could contact the issuer to make a quote request if you want to sell your call warrant.

Active quotes will not be provided where one of the exemptions set out in paragraph 3.3 of the Industry Principles applies.  For example, the liquidity providers need not provide active quotes where:

(a) the theoretical value is less than HK$0.01

(b) there is a technical failure and operational problems beyond the control of the liquidity provider; or

(c) the underlying asset or the stock market experiences exceptional price movement and high volatility over a short period of time which materially affects the liquidity provider’s hedging ability.

Remember that active quotes are not continuous. You could contact the liquidity provider, if you have any questions about liquidity.

No.  An issuer may, at its option, provide active quotes voluntarily.  In those circumstances, the issuer is not bound by the specific spread requirements for active quotes as set out in the Industry Principles.  However, in this case, the issuer will still need to comply with the spread requirement applicable to quote request in response to a quote request.